IMAGINE. How much should you learn before entering a market? New markets can be death WUDSV IRU EOLQNHUHG UPV

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1 How much should you learn before entering a market? Francis Bloch, Simona Fabrizi, Steffen Lippert New markets can be death WUDSV IRU EOLQNHUHG UPV LENGTH : 12 min (3037 words) IMAGINE you head a large carmaker, such as Volkswagen, at the start of the Chinese economic reforms in You know that an enormous market is opening up. But after decades of Chinese import-substitution policies promoting local self-reliance there is substantial uncertainty about the best way of entering the market. It is unclear, for example, what the best production and distribution alternatives are, whether you should ship your cars from Germany or manufacture locally. And if you decide on local production, you need to determine whether you should produce in one or in several facilities, where they should be located, and how best to get the products from those facilities to customers. Given that you are entering new territory, none of these questions have an easy answer. 39

2 The natural reaction to the threat of entry by competing carmakers is to pre-empt their entry. Being growing but still FLedgling market may enable you to prevent competing entry for a considerable period of time. EVEN THE COST OF ENTRY IS NOT READILY ABLE TO BE DETERMINED BEFOREHAND. EACH OF THE ALTERNATIVES HAS ITS OWN COST IMPLICATIONS, BOTH FOR THE ENTRY ITSELF AND FOR THE PROFITABILITY DOWN THE TRACK. The one certainty you do have is that other carmakers are evaluating the opportunities in China at the same time you are. The natural reaction to the uncertainties surrounding market research to determine the demand, to investigate various production and distribution alternatives, and even to experiment with alternatives, before committing to market entry. The natural reaction to the threat of entry by competing to prevent competing entry for a considerable period of time. Alternatively, one could join forces by creating a joint subsidiary to access the foreign market. If one was to go down the cooperative route, one would have to determine the best timing, how to select the best among entry. A complicating factor is that often much of the the investigation is hard to verify prior to collaborating. Note that, even though we have described the decision problem as one of companies contemplating entering are engaged in a race to obtain an innovation, they often start by building small prototypes or running small-scale experiments before investing in a large- started developing a new product, the race will often end in a merger, with one of the other before the new product reaches the decision is mediated by an outside agency, such as a venture capitalist or a granting agency. The questions of how much time to spend in experimentation, and whether to enter alone or jointly, apply here as well. The present writers explored this topic in a recent paper published in the journal Economic Theory. The focus of the research was to use an entry-timing game to better understand the interplay between information-gathering experimentation and collusive behaviour, and to study collusive in developing new products or accessing new markets. The questions we wanted or too late? How does the fact that signals decisions? When do simple compensating collusive outcome? What share of the collusive transfer scheme? And, what is the optimal time to implement cooperation? THE ROLE OF ASSUMPTIONS To answer these questions, we studied competing to enter a new market or develop a new product. However, instead of examining a host of case studies, we chose to apply economic theory. The concept salient features, possibly backed by empirical observations, strips out all non- logical implications of those features for behaviour. For our purposes, the salient features that we needed to capture were (i) varying degrees of, and uncertainty private information, which it may have an incentive to lie about to its rival. The simplest scenario containing these Of course, this does not correspond to reality there were dozens of carmakers 40 University of Auckland Business Review, Vol 19 No1,

3 ...virtually all markets fall between the extremes of a perfectly competitive industry and a monopolist whose product does not have a substitute. contemplating entry into the Chinese market in the early 1980s. So, is it a useful assumption? This is a question that can only be answered by having in mind the questions we would like to answer. As a general rule, a particular, even highly unrealistic, assumption is useful as long as the answers to our questions, which we derive make a more realistic assumption. In that case, to undertake. To give an example, virtually all markets fall between the extremes of a perfectly competitive industry and a monopolist whose product does not have a substitute. Nevertheless, we study models of perfect competition and monopoly because they teach lessons that hold true in more realistic models and, indeed, in the real world. In our case, it turns out that increasing the number of potential Further, we assumed that, to begin with, the and that it could take on two values, either low or high. We also assumed for a host of reasons that entry costs were independently distributed cost had no predictive power for the entry cost of this entry-cost assumption turns out not to be The following limitation must therefore be kept in mind: What we derived with this assumption held true only if the correlation between the common entry cost component. Firms gradually acquire signals about their entry cost through research and experimentation and, at the same time, form beliefs about the signals received by their competitors. At any point in time, irrespective of what they have duopolists only when their entry cost was low net of the entry cost, as monopolists when they had not yet learned their costs. The implication will not enter. More than two levels of entry cost would yield a qualitatively similar result providing that higher entry costs imply a lower likelihood of entering the market. COMPETITION: NO NEWS IS GOOD NEWS entry cost always enters immediately. Deferring about its own cost. Obviously, this would not necessarily hold if the competitor's entry costs were strongly positively correlated. If, in this immediately once it has learned that its entry cost is low, then its rival would infer that its own entry cost is very likely low, too, and would immediate follow suit. This suggests that the best strategy in this alternative case may be to Because, in the case with strongly idiosyncratic entry cost enters immediately, and because high do not enter, not observing the entry of one's rival amounts to valuable information. There are only two reasons why a rival may not have entered: either the rival has delayed entry because its experimentation has not yet produced information about its entry cost, or the rival has learned that it has a high entry cost and so will never enter. The latter implies becomes more and more optimistic in other words, that no news is good news. Indeed, no news may be so good that, at some point, unfruitful, enters the market regardless. In general, three equilibria are possible, depending on the expected entry cost, the and the expected entry cost is relatively high, then they will experiment and enter only when they have learned about their entry cost. If, on is slow, and the expected entry cost is not too high, then they will decide to enter without experimentation. Given more realistic degrees of patience, learning speed, and entry costs, time, they will enter the market anyway. Private information plays an important role here: business practices or R&D results, or if they simply cannot communicate them credibly to their rivals than it would be were the results of 42 University of Auckland Business Review, Vol 19 No1,

4 to invest excessively early and to experiment too little. This is generally good news for consumers, but it is bad news for the carmakers to have entered the Chinese market prematurely only to discover that this was a mistake. COOPERATION Our second set of results dealt with the likely be avoided through cooperation. But is their private information, they may lie about it. As a consequence such reports cannot be trusted, which makes optimal could seek to reach the cooperative outcome that ensured optimal investment in pre-entry experimentation and which avoided both entry cost duplication and product market competition. BUY-OUT: THERE IS A LATEST POINT enter the market, and sought to design a compensating payment scheme that gives designing a compensating payment scheme that encourages such behaviour. First, when a market, it becomes less inclined to buy willingness to pay for avoiding competition. Of course the rival may well have delayed entering because its experimentation was not yet successful, in which case it would rather continue experimenting than accept at a certain point a buy-out is rendered convinced that the rival has dropped its entry plans, and is unwilling to compensate it at a level that would prevent entry. Second, we found that even within the attention to their sharing rule. To achieve surplus should be shared between the active over should be large enough to give it an incentive to invest as soon as it learns its cost. over target should be large enough to discourage early entry in order to pre-empt its rival. First, we looked at payments made by one could buy out its competitor, or acquire its personnel devoted to the new market. We assumed, however, that it was jointly optimal cost in order to determine the right way to 44 University of Auckland Business Review, Vol 19 No1,

5 THE HIGHER THE PAYOFF TRANSFERRED TO THE FIRM WHOSE PROJECT IS NOT SELECTED, THE SMALLER THE GAP BETWEEN THE PAYOFFS OF THE LEADING AND TRAILING FIRMS... COOPERATION NO. 2: MEDIATED INVESTMENT before successfully completing the experimentation. entry decisions were mediated by a third party? This With this second scheme, we found that it was possible to implement the cooperative outcome at any point in to learn their cost. Our analysis thus sheds light on situations of project research programmes and a third party can enforce a party + might be a venture capitalist, for example, or a granting agency running a competing research project. Or it could be the editor of an academic journal, or the that two teams of scientists are working on the same problem. Our analysis suggests that selection should projects are known), nor too late (when it has become which is not selected should be neither too large in delay the research project nor too small. The higher due to excess momentum. SUMMARY Volkswagen began its exploration of the Chinese with a state-owned enterprise in China, Shanghai Volkswagen Automotive, in late American Motors, the maker of Jeep, began negotiations to sell its vehicles in China in 1979, and entered the Chinese market with joint-venture partner Beijing Jeep, a Chinese SOE, in early The fortunes of the two many years. While Volkswagen thrived, American Motors faltered, partly due to outdated models, but mostly as a result of clashes in corporate culture. What Volkswagen had learned in its early, small-scale joint venture, led the company to invest in FAW- Volkswagen Automotive, a largescale manufacturer that produced thousands of vehicles each day. In 1988 German carmaker Daimler began cooperating with the FAW group to make relatively small numbers of Mercedez Benz cars in China. When it acquired Beijing Jeep through a merger with Chrysler, Daimler decided to use the lessons learned by American Motors, Further Reading extending the initial 20-year joint venture contract by another 30 years, investing heavily, and transitioning to large-scale production of Mercedes cars in China. It seems that the initial joint-venture investments by both companies in 1984 were done with little previous learning about how to enter the Chinese market. The later, larger investments were then made only after learning that resulted from the small-scale joint ventures. Our theory suggests that both companies investigating the optimal way to enter the market. Pre-emptive pressure led them to enter prematurely, and to learn lessons the hard way. collusion in new markets with uncertain entry costs', Economic Theory KEY TAKE-OUTS The outcomes and costs of entry into new markets are inherently uncertainty through experimentation. If the results of market investigation is not disclosed, as time passes With 'private learning', the founding of a joint subsidiary can only happen becomes reluctant to buy it out. experimentation. Francis Bloch is a Professor of Economics at Université Paris 1 and the Paris School of Economics. His research interests include coalition and network theory, and public and development economics. Simona Fabrizi is a Senior Lecturer in Economics at Massey University. She is a founding member of the Research Network for Applied and Theoretical Economics, and a member of the University of Auckland s Centre for Mathematical Social Sciences. Dr Steffen Lippert is a Senior Lecturer in the University of Auckland Business School's Department of Economics. His research interests include industrial economics, and the economics of innovation. He is a co-founder of the Research Network for Applied and Theoretical Economics (ATE). s.lippert@auckland.ac.nz 46 47